Commentary: Is It OK to Be Leveraged and Short?

Despite ballooning assets and increased trading volume, leveraged and short ETFs are coming under attack. A mid-year regulatory alert sent to financial professionals by the Financial...

By Staff Writer|September 01, 2009 at 04:00 AM|Originally published on Research Magazine

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Despite ballooning assets and increased trading volume, leveraged and short ETFs are coming under attack.

A mid-year regulatory alert sent to financial professionals by the Financial Industry Regulatory Authority (FINRA) warned: “It is important that members [brokers and advisors] make every effort to familiarize themselves with each customer’s ability to meet the risks involved with such products.”

In July, Edward Jones halted its sales of leveraged ETFs. The St. Louis-based company argues these types of ETFs aren’t suitable for long-term investors.

Are leveraged and short ETFs right for your clients?

If your clients has a very short investment time horizon of a few weeks or even just a few days, then leveraged and short ETFs could be right for this person. That’s Before you answer this question, here are three key things to keep in mind: time horizon, risk tolerance and investment goals.

because the investment objective of virtually all leveraged and short ETFs is to achieve short-term investment results that correspond to the daily inverse or daily magnified performance. Let’s analyze one example. The Direxion Daily Financial Bull 3x Shares (FAS) attempts to deliver three times the daily performance of financial stocks within the Russell 1000 Financial Services Index. If this particular benchmark increases in value by 1 percent on any given day, FAS tries to obtain a 3 percent gain. But remember, leverage is a double-edged sword that can cut your pockets wide open. If financial services stocks decline by 1 percent on any given day, FAS as designed should fall by 3 percent.

Investors who want to bet on the long-term gains or losses of a particular asset class or industry sector should not be using daily leveraged and short ETFs. It’s that simple. The next iteration of these funds might be better suited for investors who have an intermediate time horizon. Product developers are already working on ETFs that attempt to achieve magnified performance returns over longer time periods, not just daily results.

People with a low tolerance for high risk and volatility should avoid leveraged and short ETFs. On the other hand, people who want to make short-term bets on the direction of the market, or make a short-term hedge, should consider using these types of products.

Any investments you decide to buy for your clients should always be compatible with their ultimate investment goals. For instance, if they’re income-oriented investors, it would make little sense if the vast majority of their investments consist of growth investments that produce little or no income.

Certain ETF providers have already moved to increase product disclosures and other safety nets.

Direxion Shares recently changed the name of its entire lineup of leveraged and short ETFs to include the word “Daily.” This was a leadership move by the Boston-based fund company to help investors understand that Direxion Shares attempt to deliver daily leveraged and inverse returns of their underlying indexes.

In my view, the Securities and Exchange Commission should force ProShares, Rydex Investments and other providers of leveraged and inverse ETFs and ETNs to insert the word “Daily” into all of their product names. Properly and uniformly labeled investment products will go a long way to helping advisors and the investing public make the right financial decisions.

In the meantime, you should examine the entire spectrum of key factors before deciding whether leveraged and short ETFs are right or wrong.

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